To know which type of loan is right for you, it is worth looking at some of main differences between FHA and Conventional home loans
One of the biggest hurdles in buying a home is getting the right financing at the price. This is especially the case in the current market where banks are placing strict criteria, and requiring large down payments to get a conventional home loan. Due to the deep recession, stock market plunge and other constraints many homeowners cannot take advantage of historically low rates and the $8000 new home owner tax credit, because of the inability to get funds required for a 15% to 20% down payment. This is where FHA (Federal Housing Administration) loans can help borrowers with low cash reserves, spotty credit history or other extenuating circumstances. A FHA Loan is one that is insured by the federal government against default, which makes it more appealing to lenders. The lower risk profile of the loan means that FHA loans generally have lower interest rates than conventional loans.
Conventional or traditional home loans on the other hand have no guarantees other than the borrowers credit and financial record to repay the loan. The higher risk, means banks want more assurances and greater down payment for these types of loans.
Conventional and FHA loans may be “conforming” and “non-conforming”. Conforming loans (normally less than $417,000 in most states) follow the terms and conditions set by Government sponsored entities Fannie Mae and Freddie Mac that securitize these loans. Both FHA and Conventional loans can be fixed rate mortgage or adjustable rate.
Nonconforming loans are those that don’t meet Fannie Mae or Freddie Mac qualifications, and are also called jumbo loans
The main advantages of a FHA versus conventional loan is that the qualifying criteria for a borrower are not as strict as those on a conventional loan and the down payment or upfront equity requirements are significantly less. In today’s market, to get the best rate on conventional loans you need 15% to 20% equity (assuming good credit and employment history). FHA loans typically require around 5%, but can be as low as 3.5% of the purchase price, and most of your closing costs and fees can be included in the loan. You will to need to buy mortgage insurance though.
FHA loans will allow the borrower who has had a few “credit problems” or those without a credit history to buy a home. An FHA underwriter will require a reasonable explanation of these derogatories, but will approach a person’s credit history with a more lenient approach. Most notably, borrowers with extenuating circumstances surrounding a bankruptcy that was read what he said discharged 2 years ago can be approved for maximum financing. Conventional financing, on the other hand, would require multiple years to have passed to be eligible for consideration and relies heavily upon credit scoring. If your score is below the minimum standard, you will not qualify or you will be place in a higher rate Subprime, Alt A or A minus loan product. See this post on ways to improve your FICO Credit score
FHA loans are generally best suited to first-time homebuyer’s who don’t have a lot of money to put down on a house, average credit and worried about qualifying for a conventional loan. If a borrower does have past credit issues an FHA loan may be significantly cheaper than an alternative loan such as subprime, ALT A, or A minus. These other programs generally have higher interest rates or require a larger down payment or equity position. Many of these alternative loan products have pre payment penalties where as FHA loan do not have such penalties. However, it is important to compare the ongoing costs of a FHA loan and conventional loan to get an idea of the total cost to you.